How do debt consolidation loans work?
- Debt consolidation in a nutshell
- What is debt consolidation?
- What is a debt consolidation loan?
- How does a debt consolidation loan work?
- When is it useful?
- Where can I get a debt consolidation loan?
- Will debt consolidation affect my credit score?
- What are the alternatives?
Done correctly, a debt consolidation loan is a cost-effective tool you can use to help you pay off your debts faster and more cheaply.
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Debt consolidation in a nutshell
If you’re managing lots of different forms of expensive debt, a debt consolidation loan is a way to bundle up all those different credit agreements – credit cards, store cards and the like – into one single loan. That way, you’ll only have to keep track of one monthly repayment, and you could save money too.
That’s the summary, but there’s plenty more detail below – read on to find out exactly how they work, and how you can get the best out of them – including how to consolidate credit card debt with a personal loan.
What is debt consolidation?
Imagine you have balances outstanding on three different credit cards, and are paying 40% APR on each one.
That’s tricky for two reasons:
You have three different payments to keep track of, making it harder to manage a budget
You’re paying a relatively high interest rate, making it tough to clear the balances
Consolidating (bringing together) these debts is a possible solution. The idea is to take on a new form of credit and use it to pay off all your existing outstanding balances, so that you only have one lending agreement to keep track of.
Additionally, if you’re able to borrow at an interest rate below 40%, you can save money, since you’ll have lower interest payments.
What is a debt consolidation loan?
There are two ways to do consolidate debt: one is to use a debt consolidation loan, and the other is to use a balance transfer credit card. In this article, we’re focusing on debt consolidation loans, although we’ll also cover balance transfer credit cards towards the end of the article.
A debt consolidation loan is the name given to a personal loan which you use to pay off other debts. It generally has a fixed rate of interest, so the rate you pay is locked in (unlike, say, a variable rate mortgage), and it usually has a term of one or more years – exactly how long is up to you.
Debt consolidation loans can be unsecured or secured. An unsecured debt consolidation loan offers more protection to the borrower, and is therefore a safer form of credit.
A secured loan (sometimes called a “homeowner loan”) is one where the lender takes an asset as “security”, usually your home, meaning that the lender can take control of that asset if you fail to make loan payments. That makes it a less safe form of lending, and as a rule you should avoid taking on a secured loan to pay off unsecured forms of lending such as credit cards.
However, one advantage of secured debt consolidation loans is that they can be used to borrow larger amounts of money.
How does a debt consolidation loan work?
It’s actually pretty simple. The key steps are:
Find out exactly how much you owe your creditors – consider credit cards, store cards, personal loans and overdrafts
Once you have that figure, you know how much you need to borrow – you’ll need to find a debt consolidation loan for that amount (most lenders will allow you to choose the exact loan amount you want to borrow)
That money will usually be paid directly into your account, and you can use this new loan to pay off your outstanding creditors – at that point, you have consolidated your debt
Make the monthly payments over the lifetime of the loan – once the loan ends, you will have paid off the total amount, and hopefully saved yourself some money in the process
Loan repayments will usually be set up as a direct debit, and many providers will allow you to choose which day the repayment comes out – you can choose a day that suits you, so that you can stay in control of your income and outgoings.
For more information, we’ve put together a detailed guide on how to get a debt consolidation loan.
When is it useful?
It’s useful in two circumstances:
When you are struggling to keep track of multiple repayments
When the interest you’re paying on a new loan is lower than what you’re currently paying
The first one is pretty straightforward, but knowing whether a debt consolidation loan can save you money is a bit trickier.
Imagine you have two credit cards and a store card, each with different rates and different outstanding balances. For this example, we’ll give interest as a representative APR – that stands for annual percentage rate, and is designed to give you an idea of the total cost of a loan including loan repayments and fees.
|Outstanding balance||Interest rate (APR)|
|Credit card 1||£1,000||30%|
|Credit card 2||£2,000||40%|
In this example, you can work out the blended interest rate by weighting each interest rate by the balance outstanding. You can do the maths yourself (multiply each of the interest rates by the value, then divide the sum by the sum of the outstanding balances) or use an online loan calculator such as this one. In this case, it comes to 41%.
That means that if you can get a debt consolidation loan with a lower interest rate (anything below 41%) and don’t extend the loan term or have to pay any extra fees, you would save money.
There’s one thing to be aware of here – all other things being equal, paying off debt quickly will always save you money. Borrow £100 at 10% for a year and you’ll pay back £10; borrow the same amount at 7% for two years and you’ll repay £14. So, when you’re budgeting and considering the term of a loan, be mindful of this fact – and always aim to pay off debt as quickly as you can.
For more information on this, take a look at our guide: when is debt consolidation a good idea?
Where can I get a debt consolidation loan?
There are many companies who offer personal loans to consolidate debt. A good place to start is a loan comparison site – you can enter the amount you need and some information about your circumstances, and a comparison site will show you many of the best options for you.
Not every lender offers debt consolidation loans: generally, when you apply for a loan, you’ll be asked for the loan purpose (e.g. renovating my house, buying a new car), and it’s important that you’re honest about how you intend to use it.
Some companies will offer to manage the process for you, for a fee. In general though, debt consolidation is pretty straightforward and something you can manage yourself, so you should avoid paying for this kind of service unless you’re getting real value.
Will debt consolidation affect my credit score?
Yes – but perhaps not in the way that you think.
Applying for any kind of credit will have an impact on your credit score, partly because many lenders carry out a “hard inquiry” when you apply (this appears on your credit history), and partly because you’re increasing your credit balance.
But that doesn’t mean you’ll end up with a bad credit score. In general, a well-managed debt consolidation loan will help you to pay off your debts – and that’s a huge boost for your credit rating, as it’s one of the main things that lenders look for.
If you’re wondering whether debt consolidation will affect your credit score, there is one other thing to be aware of. When looking at your credit report and your current debts, some lenders see unused credit as a good thing (for example, having a credit card with an unused £1,000 limit on it). So when you pay off your credit cards with a debt consolidation loan, it can be a good idea to keep those accounts open. If you do decide to do this, some personal finance experts recommend that you cut up your credit cards to avoid the temptation of spending on them again.
If you want more information, we’ve written a full guide to how personal loans affect your credit score.
What are the alternatives?
The main alternative to a debt consolidation loan is a balance transfer credit card. You can use a balance transfer credit card to move all your outstanding debts onto one new credit card – and for some borrowers, these cards might even have an introductory period where the interest rate is zero. In general, borrowers with a higher credit score will be able to borrow for a longer period, while those with a poor credit history might face higher rates of interest.
As well as interest payments, you’ll usually pay a one-off fee, and this can be high – you should always make sure that the savings you’ll make by moving money across outweigh the fee.
If you’re wondering which to pick between the two, the first thing to do is check your eligibility – you might find that the decision is made for you. You’ll then need to work out which will save you the most money – that will be your preferred option.
September, 30, 2022